The prolonged low yield market over the past six years has forced many investors to search for nontraditional ways to generate income in their portfolios. Traditionally, dividend stocks, Treasuries, corporate bonds, and high yield bonds have been the standbys, fulfilling this role faithfully for decades. However, the low interest rates maintained by the Federal Reserve and shrinking credit spreads have reduced the attractiveness of these assets, especially as rates are poised to begin climbing. With the 10-year Treasury rate at ~2.6% and dividend yield on the S&P 500 at ~1.8% (compared to their 30 year averages of 5.7% and 2.35%, respectively)1, investors are shying away from low-yielding, duration heavy traditional income producing assets and flocking to higher yielding alternatives.

(Note: see our previous post on Bank Loans for an explanation of that alternative)

What are Master Limited Partnerships (MLPs)?

Most MLPs are energy and utility companies that focus on the transport of natural gas, oil, and coal. They do not generally produce these commodities and thus are not particularly affected by fluctuations in commodity prices; as long as they can collect their fees for the transmission, they can generally maintain their profitability and hence their payouts to shareholders. It is analogous to a toll-road: the cost of the vehicles does not determine the amount paid to the operator of the road. As long as there is sufficient demand for the road, the toll company will still generate revenue.

Many of the nuances in these investments come with how they are taxed by the government. Their structure dictates that they must pass along at least 90% of their profits directly to their investors. In doing so, they are able to avoid paying both state and federal corporate taxes. This burden is simply passed along to the investors who receive a schedule K-1 at tax time. This is one aspect that turns some investors away from MLPs, as K-1s are often viewed as more complicated than form 1099. Nevertheless, individual MLPs may be a good income option for investors since many of the taxes on distributions are deferred until the sale of the stock.

MLP exchange traded portfolios (ETPs)

There are currently over 1,600 available ETPs, which account for nearly $2 trillion in assets. These ETPs cover a wide array of assets, and MLPs are no exception. The largest MLP ETP, AMLP, is approaching $10B in AUM with flows of over $1.2B so far this year alone. There are also many other options, including AMJ ($6.8B) and MLPI ($2.3B), most of which have been created in the past five years.

Accessing MLPs in this form allows investors to diversify the idiosyncratic risk from individual companies while still capitalizing on higher yield.

MLP ETFs vs. ETNs

MLP ETPs come in two different forms: ETFs and ETNs. Most investors are already familiar with ETFs, but MLP ETFs work a little differently. They are taxed as C-corporations by the IRS, which means that they must pay corporate taxes on the distributions from the individual MLPs before passing the payment along to the investor. This can cause them to deviate considerably from the index they are tracking.

It gets even more complicated when we look at how they account for the tax burden. When the ETF receives a distribution from or sells one of its MLP holdings, it essentially does what an investor would do if they owned the MLP directly: it pays taxes on any taxable portion of the distribution, adjusts its cost basis for the portion that is return of capital, and pays capital gains tax on any realized gains. Since corporations do not get a tax break for long-term capital gains, these ETFs try to offset them with losses when possible.

One of the most interesting aspects of this tax issue is how unrealized capital gains are treated. An unrealized gain – either from a price increase or a basis reduction – will eventually lead to a tax payment when the MLP is sold. The ETF adjusts its NAV down to account for any tax liabilities on unrealized gains. Conversely, the ETF adjusts its NAV up to account for any tax credits attributable to unrealized losses. The manager of the ETF has an important responsibility to manage the trading to minimize taxes so that investors can reap the most benefit from lower personal income tax rates.

MLP ETNs, on the other hand, do not have to pay corporate taxes and have a much similar tax treatment overall. However, the entire ETN distribution is taxed as ordinary income with no return of capital. Not paying corporate taxes will allow the ETNs to mirror the index more closely, but these investments do come with risks not inherent to ETFs: supply and demand issues can cause deviations from the NAV since the maximum number of shares that can be issued for an ETN is 129 million, and owners of ETNs are exposed to the credit of the issuer, which can be a very real risk for investors, as 2008 showed with Lehman Brothers.

MLP Response to Rising Interest Rates

Tax issues aside, one predominant concern is how rising rates could affect MLPs. Since MLPs distribute a substantial portion of their earnings, they must issue debt or dilute their equity to raise capital. As such, rising rates would affect their ability to borrow and pressure them to increase their distributions as investors have access to less risky income elsewhere.

As a case study, we will look at the Alerian MLP Index, which tracks the performance of the 50 largest MLPs and is currently yielding around 5.1%. This index began in 1996 and has shown impressive growth relative to that of the S&P 500. The following graph shows the Alerian MLP index’s and SPY’s cumulative growth (left axis) along with the federal funds rate, 10 year U.S. Treasury rate, and Merrill Lynch U.S. BBB rated bond index yield (3 gray lines).

From the chart we can see that the federal funds rate rose appreciably over two periods:

Between Dec 1998 and May 2000, rates increased from 4.07% to 6.83%, a gain of 2.76%. During this period, the S&P 500 increased by 17.4%, and the MLP index rose by 2.8%.

From March 2004 to Sept 2006, rates increased from 1.05% to 5.34%, a gain of 4.29%. During this period, the S&P 500 increased by 23.6%, and the MLP index rose by 36.6%.

These periods also correspond roughly to when the 10 year U.S. Treasury rate was increasing. From these two periods, we can see that the MLP index severely underperformed the S&P 500 in one instance and then outperformed in another.

What was different between the two periods? In 2004 rates started lower, and while they increased more in that period, they increased at a slower average rate. An interesting note is than over the subsequent six months as rates stabilized, the MLP index returned 17.5% vs. -6.9% for the S&P 500 for the first period and 26.0% vs. 7.3% for the second. An investor who rode out the rising rates in MLPs and held on for another six months would have been better off than one who held the S&P 500.

We can dive a bit further in and expand the concept of “rates” to include corporate bond rates, which are closer to what the MLPs would have to pay. BBB bond rates spiked during the credit crisis (Jan 2008 – Oct 2008), rising 4.1% from 6.1% to 10.2%. During this period, the MLP index lost 20.5% compared to the S&P 500 loss of 28.4%, and over the next six months as credit spreads started to tighten, the MLP index only lost an additional 1.4% while the S&P 500 was down 8.3%.

How will MLPs fare when rates rise this time? If we knew, no one would have to discuss the issue. Historical data has shown that it may not be that bad, but two samples are not enough for any kind of statistical test – three are not much better. Ultimately, it will depend on which rates rise, how much they increase, how quickly they climb, and when these increases take place relative to other economic trends.

Our View

Once you have decided on an MLP index you would like to track, choosing a specific investment vehicle, either an ETF or an ETN, is based your portfolio objectives. On the highest level, buy the ETF if you are focused on current income or care about deferring taxes over a longer horizon; buy the ETN if you care about total return or are holding the investment in a tax deferred account, bearing in mind the credit risk in the ETN structure.

MLPs, like convertible bonds and preferred securities, come with both equity-like and bond-like risks. While rising interest rates will put pressure on MLPs, economic growth can bolster their case by keeping credit spreads low. Any fixed rate financing that MLPs were able to lock in in this artificially low rate environment could also mitigate exposure they have to rising interest rates on existing debt. Additionally, the unique tax characteristics of MLP ETPs create another layer of risks that investors should be aware of.

Despite these risks, we believe that MLPs can play an important role in generating income in a well-constructed portfolio. Their low correlation to equities and bonds (less than 0.5 with the S&P 500 and near 0 with AGG) provides us with opportunities for diversification, and by accounting the risk of the MLP ETPs in the current market environment, we can prudently capitalize on the higher yield offered by these securities.

1 Robert Shiller, http://www.econ.yale.edu/~shiller/data.htm

Note: Newfound utilizes the JP Morgan Alerian MLP Index ETN (AMJ) in its Newfound Multi-Asset Income strategy. Newfound encourages investors to seek the advice of a financial advisor as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Nathan is a Vice President at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Nathan is responsible for investment research, strategy development, and supporting the portfolio management team.

Prior to joining Newfound, he was a chemical engineer at URS, a global engineering firm in the oil, natural gas, and biofuels industry where he was responsible for process simulation development, project economic analysis, and the creation of in-house software.

Nathan holds a Master of Science in Computational Finance from Carnegie Mellon University and graduated summa cum laude from Case Western Reserve University with a Bachelor of Science in Chemical Engineering and a minor in Mathematics.

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